HKMA and SFC Provide Further Guidance on Compliance with Suitability Obligations

12 April 2017

HKMA and SFC Provide Further Guidance on Compliance with Suitability Obligations

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Introduction

The Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) have issued further guidance on their expectations of the conduct requirements of financial intermediaries when selling investment products.

The SFC on 23 December 2016 published a circular together with two sets of new FAQs on the suitability requirement (Suitability Requirement) under the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (SFC Code), with one focusing on the triggering events for the Suitability Requirement (SFC Triggering FAQs) and the other on compliance with the Suitability Requirement (SFC Compliance FAQs) (together, the SFC Guidance).

On 28 December 2016 and 23 February 2017, the HKMA separately released two circulars to provide guidance to banks on its expectations for the provision of investment rationales to clients, and its risk-based supervisory approach to certain aspects of the Suitability Requirement (HKMA Guidance).

The following briefing discusses the key features of the SFC Guidance and the HKMA Guidance. The regulators have repeatedly emphasised that suitability is a cornerstone of investor protection. In light of the evolving market environment, it is a timely reminder for intermediaries to consider how these might impact their existing business practices, and assess whether staff training should be supplemented and internal processes and controls enhanced.

Key Features

During the consultation of the proposed amendments to the professional investor regime and client agreement requirements in 2013, the SFC consulted the public on their views of the Suitability Requirement. The feedback received was extensive. The majority of the responses requested the SFC to provide more guidance and clarification on the Suitability Requirement, in particular, the circumstances in which the Suitability Requirement would be likely to be triggered and, if triggered, the steps that should be taken to satisfy compliance with the obligations. In response to public comments, the SFC indicated in its Consultation Conclusions on the Proposed Amendments to the Professional Investor Regime and Further Consultation on the Client Agreement Requirements (September 2014) that it would conduct a detailed internal study on this topic with a view to providing further guidance. The result of this study is the SFC Guidance.

It is important to note that the Suitability Requirement (which has long been in place in the SFC Code) is a regulatory obligation, and should be distinguished from the new mandatory clause in client agreements under paragraph 6.2(i) of the SFC Code (New Clause) which, when operational, will impose contractual obligations.1 The SFC Guidance focuses on the Suitability Requirement under the SFC Code, and not the New Clause. Whether or not an intermediary has complied with the Suitability Requirement under the SFC Code is a matter for the SFC to determine, whilst the interpretation of the New Clause will ultimately be a matter for the Courts, regardless of the guidance offered by the SFC under the SFC Guidance. A copy of our previous Client Alert on the New Clause can be accessed here.

1. SFC Triggering FAQs

The SFC Triggering FAQs emphasise the importance of assessing the communications between the intermediaries and their clients leading up to and including the point of sale or advice, taking into account the overall circumstances, in assessing whether the Suitability Requirement is triggered. In particular, the SFC Triggering FAQs provide guidance on whether the Suitability Requirement is triggered when there are interactive communications with clients or when discretionary account services are provided to clients.

Interactive communications

The SFC Triggering FAQs set out some general guiding principles on the types of interactive communications between intermediaries and their clients that could potentially trigger the Suitability Requirement, as well as some specific scenarios to illustrate their application.

The key factors to consider include the content and context of the communication (e.g., whether it contains an inducement or recommendation to purchase an investment product, or whether it merely provides basic factual information and nothing more), whether the communication is targeted at specific clients, and how the communication is perceived, having regard to the totality of the actions undertaken by the intermediary.

A summary of the examples in the SFC Triggering FAQs is set out in the table below.

Discretionary accounts

The SFC has clarified that intermediaries providing discretionary account services to clients are subject to the Suitability Requirement. The SFC Triggering FAQs also include some suggestions on how to comply with the Suitability Requirement when providing discretionary account services, including clarifying that:

assessments can be conducted on a holistic basis when assessing the suitability of a mandate or predefined model investment portfolio

transactions subsequently effected in accordance with an agreed mandate or predefined model investment portfolio will not require a contemporaneous investment rationale

it will not be mandatory to provide prospectuses or other product information to clients for each and every investment for clients

2. SFC Compliance FAQs

The SFC Compliance FAQs replace the previous FAQs issued in 2007 (2007 Suitability FAQs). The SFC Compliance FAQs build on the key considerations for intermediaries outlined in the 2007 Suitability FAQs, with some added refinements such as:

Know Your Client (KYC): Elaboration of the KYC information required under paragraph 5.1 of the SFC Code irrespective of whether a solicitation or recommendation is to be made, including the client's annual income, liquid assets or net worth, the types and holding periods of investment products in which the client has invested, and the purposes of the investment.

Product Due Diligence: Highlighting that intermediaries can adopt a proportionate approach to conducting product due diligence having regard to the nature and extent of risks of the investment products. In particular, a distinction is drawn between the standard of due diligence expected for non-exchange-traded products and exchange-traded products, with an emphasis on intermediaries making their own inquiries about the risks inherent in non-exchange traded investment products, and not merely relying on third party material.

Matching: Elaboration that intermediaries are expected to conduct a thorough assessment of all relevant circumstances specific to a client, including concentration risk and the effect of an investment on the client's overall portfolio. The SFC Compliance FAQs also clarify that allocating a proportion of high risk products to a client with a low to medium risk profile may not be necessarily unsuitable, provided that this is commensurate with the overall risk-return profile of the client's portfolio and that the recommended products are likely to meet the investment objectives and other personal circumstances of the client.

Documentation: Making a distinction between the record keeping requirements for exchange and non-exchange traded products, namely, seven (7) years for non- exchange traded products, and two (2) years for exchange traded products. In addition, intermediaries are generally only required to provide the client with a copy of the investment rationale for the recommendations or solicitations at the client's request.

1The New Clause will become effective on 9 June 2017.

Key Features

The HKMA provides guidance to banks relating to selling practices from time to time. In the HKMA Guidance, the HKMA has elaborated on a few areas of common queries raised by banks and also indicated its views having regard to the SFC Guidance. It is important for banks to be aware of the expectations of both the SFC and the HKMA, and to ensure compliance with both sets of standards, taking into account their own operating models. The theme message in the HKMA Guidance is that the HKMA takes a risk-based supervisory approach.

Provision of investment rationale

In line with the documentation standards in the SFC Guidance, the HKMA has updated its requirement that banks are only required to provide the client with a copy of the investment rationale for recommendations or solicitations on the client's request.

Disclosure for frequent transactions on same product or product category

The HKMA clarifies that, while banks may adopt a risk-based approach to providing pre-trade risk disclosure to clients, they should be cautious about streamlining risk disclosure for clients making frequent transactions in the same 'product category'. Products in the same category will not necessarily share similar structures, risks and terms (e.g., plain vanilla bonds are substantially different from complex bonds) and making streamlined disclosure in such cases may not be appropriate to ensure adequate risk disclosure. The HKMA indicates that even for repeated transactions, banks should consider whether clients have sufficient understanding of the products and maintain accurate records, so as to demonstrate that proper risk disclosure was given in previous transactions.

Concentration risk

The HKMA Guidance is consistent with the SFC Guidance in that suitability assessments should have regard to the overall effect of the recommended products on the client's portfolios. The assessment should be taken on a cumulative basis, taking into account the existing holding of the investment products in the client's portfolio, and the concentration risk should be assessed on available information about the client.

The HKMA indicates that banks may adopt a risk-based approach in assessing concentration risk having regard to factors such as the risk profile and nature of a product and a client's risk tolerance level and financial situation. For example, in respect of an equity-linked product, considerations include whether the underlying stock carries substantial risk to the client and if so, the concentration risk assessment should cover the client's holding in the stock as well as other investments with the stock as the underlying.

Alternative investment products

The HKMA clarifies that it is not mandatory to "recommend" alternative products to clients for all transactions in general. The key point is that during the suitability assessment process, considerations were given as to whether any alternative products were available, and proper documentation was kept to demonstrate that the bank acted with due skill, care and diligence and in the client's best interests. This is particularly important where transactions with mismatches are carried out at the client's request.

Please note that the HKMA has issued separate guidance specific to certain types of products, such as accumulators and decumulators.

Actions to Take

In light of the recent regulatory guidance, we encourage intermediaries to undertake a thorough self-assessment of their selling process and consider the following actions:

Communications with clients

Ensure frontline staff understand the implications of their interactive communications with clients, and the circumstances in which the Suitability Requirement will be triggered,

Ensure frontline staff are experienced in engaging and communicating with clients in a manner which is consistent with the firm-wide business model (whether it be execution only, advisory or discretionary account services models).

Assessing suitability

Consider the suitability assessment procedures for different product types having regard to their nature, features and risks (in particular the standards of compliance for exchange-traded products as compared to non-exchange traded products).

Review if the suitability assessment procedures allow the adoption of a holistic approach in making suitability assessment, having regard to the overall circumstances of the client, in particular the concentration risks.

Consider the extent and degree of pre-trade disclosure required for repeated transactions for different products.

Establish appropriate record keeping policies for written and audio records and for different product types (in particular for exchange-traded products as compared to non-exchange traded products).

Conclusion

The regulators have made it clear that compliance with required standards on the selling of investment products will continue to be a supervisory focus, and that suitability is a cornerstone of investor protection. The recent guidance also reflects their collaborative efforts to ensure greater consistency in the standards of conduct expected in the market during the sales process and the supervisory approach they take.

Having the right measures in place is of paramount importance. Intermediaries in particular, will need to be prepared to comply with their suitability obligations from both a regulatory and contractual perspective, once the requirement to incorporate the New Clause into client agreements becomes effective in less than three months' time.

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